Brendan Harper, technical services manager at Friends Provident International, explains how UK pension policy is changing and examines the options available to expatriates who want to make the most of their savings
The 'Pensions Simplification' proposals will be introduced on the 6 April 2006, known as A-Day. Some of the proposals will affect the ability for non-UK residents and their employers to make contributions to UK pension schemes, which will differ from the rules in force currently. The current restrictions on the ability for non-residents to contribute to UK pensions mean that many cannot maintain contributions when they go abroad.
After April 2006, and assuming the proposed changes are implemented, anyone will be able to make contributions to a UK pension scheme, regardless of where or for how long they are resident. This means that UK expats and their employers will be able to continue to contribute to their pensions. Employers will still be able to get tax relief on the contributions, but non- residents will only be able to do so if they have UK earnings, as now.
The changes mean that, if you have a client who has moved abroad, they can continue to save in their home pension scheme. There are several advantages with this, including the convenience of only having one savings plan, and the ability to get tax relief on their contributions when they resume UK residence.
But is a UK pension the best place to direct disposable income when non-UK resident? In return for tax relief on contributions, individuals have to pay the price of certain restrictions, including the inability to access the fund until (after the changes) age 55, and, after age 75, they will not be able to leave the remaining fund to their family.
Also, when you put money into a pension, your original capital can be turned into taxable income on retirement. This is because the tax free lump sum on a pension is limited to 25% of the fund, so the fund would have to grow by 400% before an individual gets the original capital back tax free.
If someone is receiving tax relief at, say 40%, then these restrictions are possibly worth it. However, is it worth it in the case of an expatriate who has no UK earnings? Are there any alternative ways to save for retirement?
what are the options?
Offshore life policies are one possibility. When investments are held within a life policy, the tax treatment is exactly the same as that of a UK pension fund, in other words, UK dividends are collected net of a non-reclaimable 10% tax credit, and capital gains are tax free. Contributions to a life policy do not receive tax relief, but in the case of a non-resident with no UK earnings, this means that the position between a policy and a pension is neutral.
However, on encashment, or vesting in the case of the pension, the position is very different. Firstly, there are no restrictions on when you can take the benefits, so the client could start taking benefits before they retire - very useful, for example, if someone wishes to work part-time from say age 50, and needs to supplement income. The client can also leave the remaining fund to their heirs.
Secondly, the benefits can be taken in a tax efficient way. For example, by owning the contract with your spouse, and splitting the tax bill between you. Pensions are non-assignable, so the tax bill cannot be split in this way.
Also, on full encashment, the capital is 100% deductible from the proceeds, which means part of the income will always be tax-free.
Another major advantage is that the gains on an offshore life policy can be reduced directly in proportion to the time the policyholder spent as a non-UK resident. If an expatriate contributes to a UK pension fund, they do not receive any relief later for the period of non-residence - the income is still taxable in full.
Finally, when one takes an income from a pension fund, after deduction of the personal allowance, the income is put through the tax bands. This means that the client begins to pay tax at the higher rate after they have used up their basic rate band (currently £32,400).
Life policies, however, have the added advantage of allowing a policyholder to claim top-slicing relief. This reduces the tax bill for those who are in the basic or starting rate of tax where a policy gain takes them into the higher rate of tax.
For example, if an individual were to take out an offshore policy each year for £50,000 over a 10-year period, and then they return to the UK. If, one year later they retire, they could surrender one policy per year to provide an income. Assuming bands and allowances rise by 2.5% pa inflation, then the tax position would be as shown in table one.
So, the proceeds of £89,542 are totally tax-free. The taxable amount would increase each year, but is unlikely that it would never be subject to higher rate tax.
If this were pension income, then the pension would be taxed as seen in table two. This is a difference of £25,593. Certainly worth considering.
So, instead of putting all your eggs in the one pension basket, why not spread savings over several tax efficient plans? After April 2006, it will be possible to take your tax-free lump sum on retirement with no requirement to take any income in drawdown. This means better opportunities to withdraw gains from policies in a tax efficient manner, as there will be more scope for a client to have little or no other income to which the bond gains would be added. The personal allowance and lower and basic rate tax bands will grow by inflation, so more of the gains will escape tax at the higher rate the longer the money is invested.
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